Principles of corporate finance - Richard A. Brealey, Stewart C. Myers, Franklin Allen

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Corporate Finance

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THE MCGRAW-HILL/IRWIN SERIES IN FINANCE, INSURANCE, AND REAL ESTATE

Stephen A. Ross, Franco Modigliani Professor of Finance and Economics, Sloan School of Management, Massachusetts Institute of Technology, Consulting Editor

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PRINCIPLES OF CORPORATE FINANCE

Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2011, 2008, 2006, 2003, 2000, 1996, 1991, 1988, 1984, 1980 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

1 2 3 4 5 6 7 8 9 0 DOW/DOW 1 0 9 8 7 6 5 4 3 2 1 0 ISBN 978-0-07-353073-4

Vice president and director of marketing: Robin J. Zwettler Marketing director: Rhonda Seelinger

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To Our Parents

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◗ Franklin Allen

Nippon Life Professor of Finance at the Wharton School of the University of Pennsylvania. He is past president of the A merican Finance Association, Western Finance Association, and S ociety for Financial Studies. His research has focused on financial innovation, asset price bubbles, comparing financial systems, and financial crises. He is a scientific adviser at Sveriges Riksbank (Swe-den’s central bank).

◗ Stewart C. Myers

Robert C. Merton (1970) sor of Finance at MIT’s Sloan School of Management. He is past president of the American Finance Association and a research asso-ciate of the National Bureau of Economic Research. His research has focused on financing deci-sions, valuation methods, the cost of capital, and financial aspects of government regulation of busi-ness. Dr. Myers is a director of Entergy Corporation and The Brattle Group, Inc. He is active as a financial consultant.

◗ Richard A. Brealey

Professor of Finance at the London Business School. He is the former president of the European Finance Association and a former director of the American Finance Association. He is a fellow of the British Academy and has served as a special adviser to the Governor of the Bank of England and director of a number of financial institutions. Other books writ-ten by Professor Brealey include

Introduction to Risk and Return from

Common Stocks.

About the Authors

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What is new in the tenth edition? First, we have rewritten and refreshed several basic chapters. Content remains much the same, but we think that the revised chapters are simpler and flow better. These chapters

also contain more real-world examples.

• Chapter 1 is now titled “Goals and Governance of

the Firm.” We introduce financial management by recent examples of capital investment and financ-ing decisions by several well-known corporations. We explain why value maximization makes sense as a financial objective. Finally, we look at why good governance and incentive systems are needed to encourage managers and employees to work together to increase firm value and to behave ethically.

• Chapter 2 combines Chapters 2 and 3 from the

ninth edition. It goes directly into how ent values are calculated. We think that it is bet-ter organized and easier to understand in its new presentation.

• Chapter 3 introduces bond valuation. The material

here has been reordered and simplified. The ter focuses on default-free bonds, but also includes an introduction to corporate debt and default risk. (We discuss corporate debt and default risk in more detail in Chapter 23.)

• Short-term and long-term financial planning are

now combined in Chapter 29. We decided that

covering financial planning in two chapters was awkward and inefficient.

• Chapter 28 is now devoted entirely to financial

analysis, which should be more convenient to instructors who wish to assign this topic early in their courses. We explain how the financial state-ments and ratios help to reveal the value, profit-ability, efficiency, and financial strength of a real company (Lowe’s).

The credit crisis that started in 2007 dramatically

demonstrated the importance of a well-functioning financial system and the problems that occur when it ceases to function properly. Some have suggested that the crisis disproved the lessons of modern finance. On the contrary, we believe that it was a wake-up call—a call to remember basic principles, including the importance of good systems of governance, proper

◗

This book describes the theory and practice of corporate finance. We hardly need to explain why financial managers have to master the practical aspects of their job, but we should spell out why down-to-earth managers need to bother with theory.

Managers learn from experience how to cope with routine problems. But the best managers are also able to respond to change. To do so you need more than time-honored rules of thumb; you must understand

why companies and financial markets behave the way they do. In other words, you need a theory of finance.

Does that sound intimidating? It shouldn’t. Good theory helps you to grasp what is going on in the world around you. It helps you to ask the right ques-tions when times change and new problems need to

be analyzed. It also tells you which things you do not

need to worry about. Throughout this book we show how managers use financial theory to solve practical problems.

Of course, the theory presented in this book is not perfect and complete—no theory is. There are some famous controversies where financial economists can-not agree. We have not glossed over these disagree-ments. We set out the arguments for each side and tell you where we stand.

Much of this book is concerned with ing what financial managers do and why. But we also say what financial managers should do to increase

understand-company value. Where theory suggests that cial managers are making mistakes, we say so, while admitting that there may be hidden reasons for their actions. In brief, we have tried to be fair but to pull no punches.

finan-This book may be your first view of the world of ern finance theory. If so, you will read first for new ideas, for an understanding of how finance theory translates into practice, and occasionally, we hope, for entertain-ment. But eventually you will be in a position to make financial decisions, not just study them. At that point you can turn to this book as a reference and guide.

We are proud of the success of previous editions of

Principles, and we have done our best to make the

tenth edition even better.

Preface

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viii Preface

needed to make some judicious pruning. We will not tell you where we have cut out material, because we hope that the deletions will be invisible.

Each chapter of the book includes an introductory preview, a summary, and an annotated list of sug-gested further reading. The list of possible candidates for further reading is now voluminous. Rather than trying to list every important article, we have largely listed survey articles or general books. More specific references have been moved to footnotes.

Each chapter is followed by a set of basic questions,

intermediate questions on both numerical and

conceptual topics, and a few challenge questions.

Answers to the odd-numbered basic questions appear in an appendix at the end of the book.

We have added a Real-Time Data Analysis section

to chapters where it makes sense to do so. This section now houses some of the Web Projects you have seen in the previous edition, along with new Data Analy-sis problems. These exercises seek to familiarize the reader with some useful Web sites and to explain how to download and process data from the Web. Many of the Data Analysis problems use financial data that the

reader can download from Standard & Poor’s

Educa-tional Version of Market Insight, an exclusive

part-nership with McGraw-Hill.

The book also contains 10 end-of-chapter

mini-cases. These include specific questions to guide the

case analyses. Answers to the mini-cases are available to instructors on the book’s Web site.

Spreadsheet programs such as Excel are tailor-made

for many financial calculations. Several chapters now

include boxes that introduce the most useful financial

functions and provide some short practice questions.

We show how to use the Excel function key to locate the function and then enter the data. We think that this approach is much simpler than trying to remem-ber the formula for each function.

Many tables in the text appear as spreadsheets. In these cases an equivalent “live” spreadsheet appears on the book’s Web site. Readers can use these live spreadsheets to understand better the calculations behind the table and to see the effects of changing the underlying data. We have also linked end-of-chapter questions to the spreadsheets.

We conclude the book with a glossary of financial terms.

The 34 chapters in this book are divided into 11 parts. Parts 1 to 3 cover valuation and capital invest-ment decisions, including portfolio theory, asset management incentives, sensible capital structures,

and effective risk management.

We have added examples and discussion of the

crisis throughout the book, starting in Chapter 1

with a discussion of agency costs and the importance of good governance. Other chapters have required significant revision as a result of the crisis. These

include Chapter 12, which discusses executive pensation; Chapter 13, where the review of market

com-efficiency includes an expanded discussion of asset

price bubbles; Chapter 14, where the section on

financial institutions covers the causes and progress

of the crisis; Chapter 23, where we discuss the AIG debacle; and Chapter 30, where we note the effect of

the crisis on money-market mutual funds.

The first edition of this book appeared in 1981. Basic principles are the same now as then, but the last three decades have also generated important changes in the-ory and practice. Research in finance has focused less on what financial managers should do, and more on understanding and interpreting what they do in prac-tice. In other words, finance has become more positive and less normative. For example, we now have careful surveys of firms’ capital investment practices and pay-out and financing policies. We review these surveys and look at how they cast light on competing theories.

Many financial decisions seem less clear-cut than they were 20 or 30 years ago. It no longer makes sense to ask whether high payouts are always good or always bad, or whether companies should always borrow less or more. The right answer is, “It depends.” Therefore we set out pros and cons of different policies. We ask “What questions should the financial manager ask when setting financial policy?” You will, for example, see this shift in emphasis when we discuss payout deci-

sions in Chapter 16.

This edition builds on other changes from earlier editions. We recognize that financial managers work more than ever in an international environment and therefore need to be familiar with international dif-ferences in financial management and in financial

markets and institutions. Chapters 27 (Managing International Risks) and 33 (Governance and Cor-porate Control around the World) are exclusively

devoted to international issues. We have also found

more and more opportunities in other chapters to draw cross-border comparisons or use non-U.S. examples. We hope that this material will both provide a better understanding of the wider financial environment and be useful to our many readers around the world.

As every first-grader knows, it is easier to add than to subtract. To make way for new topics we have

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Mark Garmaise University of California, Los Angeles Sharon Garrison University of Arizona

Christopher Geczy University of Pennsylvania George Geis University of Virginia

Stuart Gillan University of Delaware Felix Goltz Edhec Business School Ning Gong Melbourne Business School Levon Goukasian Pepperdine University Gary Gray Pennsylvania State University C. J. Green Loughborough University

Mark Griffiths Thunderbird, American School of

Mary Hartman Bentley College

Glenn Henderson University of Cincinnati Donna Hitscherich Columbia University Ronald Hoffmeister Arizona State University James Howard University of Maryland, College Park George Jabbour George Washington University Ravi Jagannathan Northwestern University Abu Jalal Suffolk University

Nancy Jay Mercer University

Kathleen Kahle University of Arizona Jarl Kallberg NYU, Stern School of Business Ron Kaniel Duke University

Steve Kaplan University of Chicago Arif Khurshed Manchester Business School Ken Kim University of Wisconsin, Milwaukee C. R. Krishnaswamy Western Michigan University George Kutner Marquette University

Dirk Laschanzky University of Iowa David Lins University of Illinois, Urbana

pricing models, and the cost of capital. Parts 4 to 8 cover payout policy, capital structure, options (includ-ing real options), corporate debt, and risk manage-ment. Part 9 covers financial analysis, planning, and working-capital management. Part 10 covers mergers and acquisitions, corporate restructuring, and corpo-rate governance around the world. Part 11 concludes.

We realize that instructors will wish to select topics and may prefer a different sequence. We have there-fore written chapters so that topics can be introduced in several logical orders. For example, there should be no difficulty in reading the chapters on financial analysis and planning before the chapters on valua-tion and capital investment.

We have a long list of people to thank for their ful criticism of earlier editions and for assistance in preparing this one. They include Faiza Arshad, Alei-jda de Cazenove Balsan, Kedran Garrison, Robert Pindyck, Sara Salem, and Gretchen Slemmons at MIT; Elroy Dimson, Paul Marsh, Mike Staunton, and Stefania Uccheddu at London Business School; Lynda Borucki, Michael Barhum, Marjorie Fischer, Larry Kolbe, Michael Vilbert, Bente Villadsen, and Fiona Wang at The Brattle Group, Inc.; Alex Trian-tis at the University of Maryland; Adam Kolasinski at the University of Washington; Simon Gervais at Duke University; Michael Chui at The Bank for Inter-national Settlements; Pedro Matos at the University of Southern California; Yupana Wiwattanakantang at Hitotsubashi University; Nickolay Gantchev, Tina Horowitz, and Chenying Zhang at the University of Pennsylvania; Julie Wulf at Harvard University; Jin-ghua Yan at Tykhe Capital; Roger Stein at Moody’s Investor Service; Bennett Stewart at EVA Dimensions; and James Matthews at Towers Perrin.

We want to express our appreciation to those instructors whose insightful comments and suggestions were invaluable to us during the revision process:

Neyaz Ahmed University of Maryland Anne Anderson Lehigh University Noyan Arsen Koc University

Anders Axvarn Gothenburg University Jan Bartholdy ASB, Denmark Penny Belk Loughborough University Omar Benkato Ball State University Eric Benrud University of Baltimore Peter Berman University of New Haven Tom Boulton Miami University of Ohio Edward Boyer Temple University

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x Preface

David Lovatt University of East Anglia Debbie Lucas Northwestern University Brian Lucey Trinity College, Dublin

Suren Mansinghka University of California, Irvine Ernst Maug Mannheim University

George McCabe University of Nebraska

Eric McLaughlin California State University, Pomona Joe Messina San Francisco State University

Dag Michalson Bl, Oslo

Franklin Michello Middle Tennessee State University Peter Moles University of Edinburgh

Katherine Morgan Columbia University

Darshana Palkar Minnesota State University, Mankato Claus Parum Copenhagen Business School

Dilip Patro Rutgers University

John Percival University of Pennsylvania Birsel Pirim University of Illinois, Urbana Latha Ramchand University of Houston Rathin Rathinasamy Ball State University Raghavendra Rau Purdue University Joshua Raugh University of Chicago Charu Reheja Wake Forest University

Thomas Rhee California State University, Long Beach Tom Rietz University of Iowa

Robert Ritchey Texas Tech University Michael Roberts University of Pennsylvania Mo Rodriguez Texas Christian University John Rozycki Drake University

Frank Ryan San Diego State University Marc Schauten Eramus University Brad Scott Webster University Nejat Seyhun University of Michigan Jay Shanken Emory University

Chander Shekhar University of Melbourne Hamid Shomali Golden Gate University Richard Simonds Michigan State University Bernell Stone Brigham Young University John Strong College of William & Mary

Avanidhar Subrahmanyam University of California,

Los Angeles

Tim Sullivan Bentley College

Shrinivasan Sundaram Ball State University Chu-Sheng Tai Texas Southern University Stephen Todd Loyola University, Chicago

Walter Torous University of California, Los Angeles Emery Trahan Northeastern University

Ilias Tsiakas University of Warwick Narendar V. Rao Northeastern University David Vang St. Thomas University Steve Venti Dartmouth College Joseph Vu DePaul University John Wald Rutgers University

Chong Wang Naval Postgraduate School Kelly Welch University of Kansas

Jill Wetmore Saginaw Valley State University Patrick Wilkie University of Virginia Matt Will University of Indianapolis Art Wilson George Washington University Shee Wong University of Minnesota, Duluth Bob Wood Tennessee Tech University Fei Xie George Mason University

Minhua Yang University of Central Florida Chenying Zhang University of Pennsylvania

This list is surely incomplete. We know how much we owe to our colleagues at the London Business School, MIT’s Sloan School of Management, and the Univer-sity of Pennsylvania’s Wharton School. In many cases, the ideas that appear in this book are as much their ideas as ours.

We would also like to thank all those at Hill/Irwin who worked on the book, including Michele Janicek, Executive Editor; Lori Koetters, Managing Editor; Christina Kouvelis, Senior Devel-opmental Editor; Melissa Caughlin, Senior Mar-keting Manager; Jennifer Jelinski, Marketing Specialist; Karen Fisher, Developmental Editor II; Laurie Entringer, Designer; Michael McCormick, Lead Production Supervisor; and Sue Lombardi Media Project Manager.

Finally, we record the continuing thanks due to our wives, Diana, Maureen, and Sally, who were unaware when they married us that they were also marrying the

Principles of Corporate Finance.

Richard A. Brealey Stewart C. Myers Franklin Allen

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Each chapter begins with a brief narrative and outline to explain the concepts that will be covered in more depth. Useful Web sites related to material for each Part are provided on the book’s Web site at

New to this edition! Numbered

and titled examples are called-out within chapters to further illustrate concepts. Students can learn how to solve specific problems step-by-step as well as gain insight into general principles by seeing how they are applied to answer concrete ques-tions and scenarios.

Pedagogical Features

Guided Tour

EXAMPLE 2.3 ● Winning Big at the Lottery

When 13 lucky machinists from Ohio pooled their money to buy Powerball lottery tickets, they won a record $295.7 million. (A fourteenth member of the group pulled out at the last minute to put in his own numbers.) We suspect that the winners received unsolicited congratulations, good wishes, and requests for money from dozens of more or less worthy charities. In response, they could fairly point out that the prize wasn’t really worth $295.7 million. That sum was to be repaid in 25 annual installments of $11.828 million each. Assuming that the first payment occurred at the end of one year, what was the present value of the prize? The interest rate at the time was 5.9%.

These payments constitute a 25-year annuity. To value this annuity we simply multiply $11.828 million by the 25-year annuity factor:

PV⫽ 11.828 ⫻ 25-year annuity factor⫽ 11.828 ⫻ B1r⫺ 1

Corporations invest in real assets, which generate cash inflows and income. Some of the assets are tangible

of these things, it does cover the concepts that govern good financial decisions, and it shows you how to use the tools of the trade of modern finance.

We start this chapter by looking at a fundamental trade-off. The corporation can either invest in new

Goals and Governance of the Firm

FINANCE IN PRACTICE

◗ Stock markets allow investors to bet on their ite stocks. Prediction markets allow them to bet on almost anything else. These markets reveal the collec-tive guess of traders on issues as diverse as New York City snowfall, an avian flu outbreak, and the occur-rence of a major earthquake.

Prediction markets are conducted on the major futures exchanges and on a number of smaller online exchanges such as Intrade ( www.intrade.com ) and the Iowa Electronic Markets ( www.biz.uiowa.edu/iem ). Take the 2008 presidential race as an example. On the Iowa Electronic Markets you could bet that Barack Obama would win by buying one of his con-tracts. Each Obama contract paid $1 if he won the

and selling, the market price of a contract revealed the collective wisdom of the crowd.

Take a look at the accompanying figure from the Iowa Electronic Markets. It shows the contract prices for the two contenders for the White House between June and November 2008. Following the Republican convention at the start of September, the price of a McCain contract reached a maximum of $.47. From then on the market suggested a steady fall in the prob-ability of a McCain victory.

Participants in prediction markets are putting their money where their mouth is. So the forecasting accu-racy of these markets compares favorably with those of major polls. Some businesses have also formed inter-ldi ikhif h i

Prediction Markets

bre30735_ch13_312_340.indd 33110/12/09 5:21:20 PM

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Functions Boxes

New to this edition! These boxes

provide detailed examples of how to use Excel spreadsheets when applying financial concepts. Ques-tions that apply to the spreadsheet follow for additional practice.

Select exhibits are set as Excel spreadsheets and have been denoted with an icon. They are also available on the book’s Web site at

www.mhhe.com/bma .

deviationsProduct of

(7)from average

returns(cols 4 ⴛ 5)

(6)deviationfrom averagemarket return

(5)from average

Anchovy Qreturn

(4)fromaveragemarket return

Anchovy Qreturn

Beta (b ) = σim/σm2 = 76/50.67 = 1.5Covariance = σim = 456/6 = 76Variance = σm2 = 304/6 = 50.67

◗ TABLE 7.7 Calculating the variance of the market returns and the covariance between the returns on the market and those of Anchovy Queen. Beta is the ratio of the variance to the covariance (i.e., ␤ 5 ␴ im/␴m2 ).

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◗ Spreadsheet programs such as Excel provide built-in functions to solve for internal rates of return. You can

find these functions by pressing fx on the Excel toolbar.

Excel will guide you through the inputs that are required. At the bottom left of the function box there is a Help facility with an example of how the function is used.

Here is a list of useful functions for calculating internal rates of return, together with some points to remember when entering data:

• IRR: Internal rate of return on a series of

regularly spaced cash flows.

• XIRR: The same as IRR, but for irregularly

spaced flows.

Note the following:

• For these functions, you must enter the addresses of the cells that contain the input values.

• The IRR functions calculate only one IRR even when there are multiple IRRs.

3. (IRR) Now use the function to calculate the IRR

on Helmsley Iron’s mining project in Section 5-3 . There are really two IRRs to this project (why?). How many IRRs does the function calculate?

4. (XIRR) What is the IRR of a project with the

fol-lowing cash flows:

⫺$215,000 . . . ⫹$185,000 . . . ⫹$85,000 . . . ⫹$43,000

(All other cash flows are 0.)

Internal Rate of Return

USEFUL SPREADSHEET FUNCTIONS

Excel Treatment

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New end-of-chapter lems are included for even more hands-on practice. We have separated the questions by level of difficulty: Basic, Intermediate, and Challenge. Answers to the odd-numbered basic questions are included at the back of the book.

Most chapters contain lems, denoted by an icon, specifically linked to Excel templates that are available on the book’s Web site at

prob-www.mhhe.com/bma .

End-of-Chapter Features

BASIC

1. Suppose a firm uses its company cost of capital to evaluate all projects. Will it

underesti-mate or overestiunderesti-mate the value of high-risk projects?

2. A company is 40% financed by risk-free debt. The interest rate is 10%, the expected

mar-ket risk premium is 8%, and the beta of the company’s common stock is .5. What is the co mpany cost of capital? What is the after-tax WACC, assuming that the company pays tax at a 35% rate?

3. Look back to the top-right panel of Figure 9.2 . What proportion of Amazon’s returns was

explained by market movements? What proportion of risk was diversifiable? How does the diversifiable risk show up in the plot? What is the range of possible errors in the estimated beta?

PROBLEM SETS

INTERMEDIATE

11. The total market value of the common stock of the Okefenokee Real Estate Company is $6

million, and the total value of its debt is $4 million. The treasurer estimates that the beta of the stock is currently 1.5 and that the expected risk premium on the market is 6%. The Treasury bill rate is 4%. Assume for simplicity that Okefenokee debt is risk-free and the company does not pay tax.

a. What is the required return on Okefenokee stock? b. Estimate the company cost of capital.

c. What is the discount rate for an expansion of the company’s present business? d. Suppose the company wants to diversify into the manufacture of rose-colored specta-

cles. The beta of unleveraged optical manufacturers is 1.2. Estimate the required return on Okefenokee’s new venture.

12. Nero Violins has the following capital structure:

15. A 10-year German government bond (bund) has a face value of €100 and a coupon rate of 5% paid annually. Assume that the interest rate (in euros) is equal to 6% per year. What is the bond’s PV?

16. A 10-year U.S. Treasury bond with a face value of $10,000 pays a coupon of 5.5% (2.75%

of face value every six months). The semiannually compounded interest rate is 5.2% (a month discount rate of 5.2/2 ⫽ 2.6%).

a. What is the present value of the bond?

b. Generate a graph or table showing how the bond’s present value changes for semiannually compounded interest rates between 1% and 15%.

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CHALLENGE

23. Suppose you are valuing a future stream of high-risk (high-beta) cash outflows. High risk

means a high discount rate. But the higher the discount rate, the less the present value. This seems to say that the higher the risk of cash outflows, the less you should worry about them! Can that be right? Should the sign of the cash flow affect the appropriate discount rate? Explain.

24. An oil company executive is considering investing $10 million in one or both of two wells:

well 1 is expected to produce oil worth $3 million a year for 10 years; well 2 is expected to

produce $2 million for 15 years. These are real (inflation-adjusted) cash flows.

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chap-is provided free with the

pur-chase of a new book.

To enhance concepts cussed within a chapter, mini-cases are included in select chapters so students can apply their knowledge to real-world scenarios.

dis-● ●●● ●

You can download data for the following questions from the Standard & Poor’s Market Insight Web site ( www.mhhe.com/edumarketinsight )—see the “Monthly Adjusted Prices” spreadsheet—or from finance.yahoo.com. Refer to the useful Spreadsheet Functions box near the end of Chapter 9 for information on Excel functions.

1. Download to a spreadsheet the last three years of monthly adjusted stock prices for

Coca-Cola (KO), Citigroup (C), and Pfizer (PFE). a. Calculate the monthly returns.

b. Calculate the monthly standard deviation of those returns (see Section 7-2). Use the Excel function STDEVP to check your answer. Find the annualized standard deviation by multiplying by the square root of 12.

c. Use the Excel function CORREL to calculate the correlation coefficient between the monthly returns for each pair of stocks. Which pair provides the greatest gain from diversification?

d. Calculate the standard deviation of returns for a portfolio with equal investments in the three stocks.

2. Download to a spreadsheet the last five years of monthly adjusted stock prices for each of

the companies in Table 7.5 and for the Standard & Poor’s Composite Index (S&P 500). a. Calculate the monthly returns.

b. Calculate beta for each stock using the Excel function SLOPE, where the “y” range refers to the stock return (the dependent variable) and the “x” range is the market return (the independent variable).

c. How have the betas changed from those reported in Table 7.5 ?

3. A large mutual fund group such as Fidelity offers a variety of funds. They include sector

funds that specialize in particular industries and index funds that simply invest in the market

index. Log on to www.fidelity.com and find first the standard deviation of returns on the Fidelity Spartan 500 Index Fund, which replicates the S&P 500. Now find the standard deviations for different sector funds. Are they larger or smaller than the figure for the index fund? How do you interpret your findings?

REAL-TIME DATA ANALYSIS

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Waldo County

Waldo County, the well-known real estate developer, worked long hours, and he expected his staff to do the same. So George Chavez was not surprised to receive a call from the boss just as George was about to leave for a long summer’s weekend.

Mr. County’s success had been built on a remarkable instinct for a good site. He would exclaim “Location! Location! Location!” at some point in every planning meeting. Yet finance was not his strong suit. On this occasion he wanted George to go over the figures for a new $90 million outlet mall designed to intercept tourists heading downeast toward Maine. “First thing Monday will do just fine,” he said as he handed George the file. “I’ll be in my house in Bar Harbor if you need me.”

George’s first task was to draw up a summary of the projected revenues and costs. The results are shown in Table 10.8 . Note that the mall’s revenues would come from two sources: The company would charge retailers an annual rent for the space they occupied and in addi-tion it would receive 5% of each store’s gross sales.

Construction of the mall was likely to take three years. The construction costs could be depreciated straight-line over 15 years starting in year 3. As in the case of the company’s other developments, the mall would be built to the highest specifications and would not need to be rebuilt until year 17. The land was expected to retain its value, but could not be depreciated for tax purposes.

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